INTRO TO STOCK OPTIONS

12-30-2015

Oftentimes a business desires to compensate key employees with equity. There are several tools to accomplish this, including restricted stock, restricted stock units, stock appreciation rights, and employee stock purchase plans. Each of these plans is designed to compensate an employee through some special consideration regarding the terms or price of a company’s stock. But the stock option is by far the most common of these tools.

If you are granted a stock option, what you have is a right to buy a certain amount of shares at a fixed price for a set number of years. The price is fixed at the grant. For example X Inc. may give you the option to buy up to 1000 shares of X Inc. stock at $10/share, with the options having a term of 6 years (the option may be held for 6 years before expiring). The exercise of options is usually restricted through a vesting schedule, companies will usually either set time-based vesting schedules or have the options vest once some goal or metric is met (often times a combination of both of these is used). For example, your options may be subject to a four (4) year vesting period, but could be set to fully vest earlier if you sell $1 million worth of X’s product.

Because an option is a right to buy, you do not have to pay the purchase price when the option vests, only when you exercise it. For instance, if all 1000 of your options vest in Year 1 at a $10/share price, you do not have to pay anything yet. In Year 2, the price of X’s stock goes down from $10/share to $8. In this case you would not want to exercise your options because you would be paying $10/share and receiving only $8/share in value, taking a loss of $2/share. If in Year 5 the stock goes up to $25 a share, you may choose to exercise your options and pay $10 for each option you chooses to exercise. This payment can be made in different ways: in cash, by liquidating some of the options, etc... The spread on this exercise, the difference between the exercise price of the option ($10) and the fair market value of the stock at the time of exercise ($25), would be $15 (as oppose to a negative $2 spread if you exercised in Year 2).

The tax consequences of exercising the option depend on the type of stock option plan A is a part of.

Types of Stock Options

There are two types of Options: nonqualified stock options (NSOs), sometimes also referred to as nonstatutory stock options, and incentive stock options (ISOs).

An NSO is any stock option which is not an ISO. When you exercise an NSO the spread is taxable as ordinary income even if the shares have not been sold, but any subsequent gain or loss is treated as capital gain or loss when the shares are sold. If the spread on your exercise of an NSO is $1,000,000, for example, that could mean up to $350,000 in tax liability without your actually having gotten any cash from the NSO. On the upside, a corresponding amount is deductible by the company issuing the NSO. NSOs are also more flexible in that there is no required holding period (although the company may impose one).

An ISO gives you the benefit of having all gain, including the spread, treated as capital gain, and deferring tax on options until the shares are actually sold. Although an ISO seems like a no-brainer, on the down side the company does not get to take a tax deduction, there may also be Alternative Minimum Tax (AMT) repercussions upon the exercise of ISOs, and it may be difficult to qualify for ISO treatment. In order for an option to qualify as an ISO, several conditions must be met:

  1. You must hold the stock for at least two years after the grant of an option and one year after exercise
  2. Only $100,000 of stock options may become exercisable in a calendar year, as measured by the fair market value of the option on the grant date.
  3. The exercise price must be at least the fair market value of the company’s stock on the date of the grant. (See IRC 409A)
  4. ISOs may only be issued to employees
  5. The option must be granted pursuant to a written plan approved by shareholders. The plan must specify the option pool size and the class of employees eligible to receive options. Options must be granted within ten (10) years of the board of director’s adopting the plan.
  6. Options must be exercised within ten (10) years of the grant date.
  7. If an employee owns more than 10% of the voting power of all outstanding stock of the Company at the time of the grant, the exercise price must be at least 110% of the fair market value of the stock on the grant date and must have a five (5) year or shorter term.


It is important to carefully structure stock options and stock option plans in a manner that maximizes your net benefit, taking into account their effects on both the grantor (the company) and the recipients (the employees/executives). Oftentimes this means lowering your tax bill using an ISO while making sure not to run into the AMT, but sometimes the deductibility and flexibility of an NSO is the best decision for your business.